Climate change and Carbon policy: A story of optimal green macroprudential and capital flow management

Abstract

This paper investigates the macro-financial impact of carbon policy and the role of reserve requirements in managing climate-related transition risks. Empirical evidence shows that carbon policy shocks lead to a 0.7% output loss, a 0.3% rise in inflation, financial instability, and sectoral reallocation effects. Using a macro-financial DSGE model with environmental features, the model predicts that a 40% GHG emissions reduction results in a 0.7% output loss, while achieving net-zero emissions over 30 years causes a 2.7% medium-term output loss. The analysis underscores the banking sector’s amplified role during the transition and the benefits of pre-announced carbon policies in reducing inflation volatility by 0.2%. Utilizing a heterogeneous approach with macroprudential tools, I find that optimal macroprudential tools can mitigate the output loss by 0.1% and investment loss by 0.5%. Importantly, my work highlights the use of capital flow management in the green transition.